What is Return On Assets (ROA)?

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Definition:

Return on assets (ROA) is a measure of how effective a company is at using its assets to generate profit.

🤔 Understanding return on assets

Return on assets (ROA) measures profitability, in relation to the total assets a company holds. This ratio can tell a financial analyst or potential investor how effectively the company is using its assets to create profits. The assets used in this measurement are those that a company lists on its balance sheet. By calculating assets along with a company’s net income (aka profit), you can find a company’s ROA. The result of the calculation is a percentage, which represents the total return on assets. Because investors want to see that a company is making money efficiently, generally speaking the higher the ROA, the better.

Example

Let’s say Joan is considering investing in fictitious Company Z. Company Z reported on its balance sheet that it has $100,000 in total assets. Company Z’s most recent income statement shows that it generates a total of $20,000 in net income in a given period. Using the ROA formula ($20,000 ÷ $100,000), Joan determines that Company Z has a return on assets of 20%.

Takeaway

The return on assets for a company is like miles per gallon for a vehicle...

In both situations, you measure how much bang you get for your buck. In the case of the car, you measure how many miles you can drive on each tank of gas. In the case of the company, you measure how many dollars the company profits for each dollar’s worth of assets.

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What can ROA tell us?

ROA tells us how profitable a company is based on its assets. The higher the ROA, the more effectively a company is using its assets. ROA is useful for investors because rather than just showing them how much in assets a company has, the investor can see how efficiently the company is using those assets to bring in profit. Essentially, how well are they turning assets into cash? ROA is most useful when comparing different companies within the same industry, rather than comparing companies across various industries.

When it comes to ROA, higher is better. A high ROA indicates that a company is doing a good job of making use of the assets it has at its disposal. A low ROA, on the other hand, might be a sign that a company’s management is not using its assets effectively.

In addition to investors using ROA to consider their investment options in different companies, businesses themselves can use the calculation to make sure that they’re moving in the right direction.

For example, let’s say a company is considering a new piece of equipment. The company might consider the impact it expects the equipment to have on efficiency and on the company’s net profit. A piece of equipment that will increase efficiency and increase profit might be a slam dunk. However, management might reconsider investing in a piece of equipment if they don’t think it’s going to move the needle on their profits. After all, if assets increase without net profit increasing, then the ROA decreases.

A sudden decrease in ROA might mean that a company has invested in an asset that hasn’t paid off yet, but it also might mean a change in management decisions that won’t be favorable for investors.

What affects ROA?

There are three primary factors used to calculate a company’s ROA.

The first is a company’s assets, which can be found on its balance sheet. An asset is anything of value the company has, either in the form of cash, or a material item such as equipment or inventory.

There are two major types of assets: current and non-current assets. Current assets are either cash or assets that can be converted into cash within a year. Non-current assets are those that likely can’t be converted into cash within a year (or can’t be converted into cash at all). Both current and non-current assets are taken into account when determining a company’s ROA.

The two other factors that affect a company’s ROA are the revenue and the expenses, which can both be found on a company’s income statement. You can use the revenue (how much money the company brings in) and the expenses (how much money a company spends) to determine the company’s net income (revenue – expenses).

So how do these factors actually impact the ROA? Well, an increase or decrease in any one of these factors could affect the company’s ROA.

For example, let’s say a company purchases some additional equipment. This results in an increase in their assets and an increase in their expenses (though, remember that a capital expense will not be considered an expense in total, but will be added to a company’s books over the course of years as an amortized cost). The added cost may decrease the company’s ROA in the short term by cutting into profit, but it may increase ROA down the road as the investment pays off.

ROA could also be impacted by an increase or decrease in either revenue or expenses that are entirely unrelated to the company’s assets. For example, if a company’s sales were to increase, thus increasing their revenue, the ROA may also increase if the other factors remain the same.

How is ROA calculated?

ROA is calculated using a company’s total assets and net income. The formula looks like this:

Return on Assets = Net Income ÷ Total Assets

ROA is presented as a percentage. For example, let’s say a company has $500,000 worth of assets and $100,000 of net income. That company’s ROA is 20%.

What is the difference between ROA and return on equity?

Like return on assets (ROA), return on equity (ROE) is another calculation that investors can use to determine how effectively a company is using the tools it has. The critical difference is that rather than determining profitability based on a company’s assets, ROE determines profitability based on shareholder equity, meaning how much of the company is owned by shareholders. A company’s shareholder equity is the difference between its assets and its liabilities.

The formula for calculating ROE looks like this:

Return on Equity = Net Income ÷ Shareholder Equity

One benefit of ROE over ROA is that it measures the company’s effectiveness without relying just on its assets. So when you’re comparing return across different industries, ROE might give you a more accurate comparison.

ROE is also a good figure for investors to consider because it can show them how efficiently the company is using their investors’ money. This might be a more important factor if you’re considering investing in a company. You want to know they’re going to use your money as effectively as possible.

In the end, the calculations are useful when considered together. One of the formulas, ROA, measures how well a company uses its assets, but it completely ignores debts. The other formula, ROE, takes into account the debt that ROA ignored.

What is a good ROA?

In general, the higher a company’s ROA, the better. An increasing ROA shows that a company is more effectively using its assets to grow its profit. Anything over 5% is generally thought to be a respectably ROA.

That being said, ROA will differ from industry to industry. Those industries that require a lot of assets to create their product or service will have a lower ROA than those that don’t need much equipment at all. A company that builds cars is obviously going to require more machinery than a company that builds websites.

What are the limitations of ROA?

While ROA can be used by investors to determine how well a company is using its assets, it doesn’t always give us the full picture. The first limitation of the ROA formula is that it does not account for liabilities. So a company might appear to use its assets efficiently based on the ROA formula but have disproportionately high liabilities.

The other flaw of the ROA formula — and one that investors should keep in mind when comparing the ROA of different companies — is that it should not be used across industries. Various industries require different assets, and it’s difficult to accurately compare profitability across industries using information that can vary so widely. As an example, some companies need a lot of equipment to produce their products. This would give them a lower ROA than say a software company that produces software that doesn’t require extensive equipment to create again and again.

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Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

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